What is Put Call Ratio?
A Put Call Ratio or PCR is a derivative indicator used by traders to gauge the overall sentiment of the market. This ratio uses the volume of put and call options on a market index over a period to determine the market sentiment. In other words, it helps to determine the extent of bullish or bearish influence in the market.
Traders can understand whether an increase or decrease in the market is excessive or not. Based on this information, traders decide to opt for a contrarian call in the prevailing market conditions. Also, this investment strategy is based on buying or selling investment units against market conditions and taking advantage of mis pricing in the securities market.
If traders are buying more puts, it indicates a bearish market sentiment. But if traders are buying more calls, it indicates a bullish market sentiment. Moreover, PCR can be used to calculate indices, stocks, or derivative segments as a whole.
How to Calculate Put Call Ratio?
Before understanding how to calculate the Put Call Ratio, it is important to understand its components.
- The call option gives the buyer the right to purchase the underlying asset at a particular price.
- The put option gives the buyer the right to sell the underlying asset at a particular price.
- The strike price is the price at which the buyer and seller decide to buy/sell the asset at a particular price.
- Open Interest is the total outstanding option contracts in the market which are open and yet to be closed at a given time.
The following are the two ways to calculate PCR –
1) Depending on the volume of trading
PCR (Volume) = Put Volume / Call Volume
Put Volume – is the total number of put options initiated over a given time period.
Call Volume – is the total number of call options initiated in the same time period.
2) Depending on open interests on a specific day
PCR (OI) = Total Put Open Interest / Total Call Open Interest
Put Open Interest – is the total number of outstanding put contracts.
Call Open Interest – is the total number of outstanding call contracts.
A trader plans to use the Put Call Ratio to determine the market sentiment of security. The put and call initiated are –
Number of Puts – 1300
Number of Calls – 1700
PCR = Put open interest / Call open Interest
= 1300/1700 = 0.7647
Since the PCR is less than one, it indicates that traders are buying more call options than put options which depicts a bullish trend in the future.
Interpretation of Put Call Ratio
The following is the interpretation of PCR in terms of ratio –
- Less than 1 (<1): It shows that traders are purchasing more call options than put options and signals a bullish market trend going forward.
- More than 1 (>1): It shows that traders are purchasing more put options than call options and signals a bearish trend going forward.
- Equal to 1 (=1): It shows that traders are purchasing the same amount of put options and call options and signals a neutral trend going forward.
An average PCR of 0.7 for equity options is considered suitable for assessing the market. Thus, a PCR over 0.7 or 1 signifies that more traders are purchasing put options. On the other hand, a falling PCR, i.e. below 0.7 or 0.5, signifies a strong bullish market trend. Therefore, a higher ratio implies hedging, and a lower ratio indicates speculation.
The following is the interpretation of PCR in terms of investment strategy –
- Contrarian Investor: This group of traders see the PCR from a reverse perspective. This means they expect a turnaround when the ratio is higher, considering it a bullish market trend. On the contrary, the lower ratio makes them consider it a bearish market indicator as they expect a pullback.
- Momentum Investor: This group of traders considers a high PCR as a bearish trend and low PCR as a bullish trend.
Therefore, there is no correct way to interpret this ratio. It is interpreted differently by traders depending on their investment style.
Significance of Volume (Vol) and Open Interest (OI) in PCR
The PCR helps traders to invest according to the market sentiments and gain potential returns. When they engage in trading indices, it helps them to know the volume of stocks traded. This way, it helps traders in decision-making in a particular stock, sector, or index. However, they must have some knowledge about the market and PCR.
The calculation of PCR for volumes and open interest is straightforward. Also, PCR is calculated with respect to a specific strike rate. Firstly, let’s see the PCR of volumes.
For instance, the put volume in the Nifty 10,600 strike is 80,000 contracts, and the call volume for the same contract and same expiry is 1,25,000 contracts.
PCR (Vol) = 80000/125000 = 0.64
The trend of PCR over a period of time is a more reliable indicator rather than PCR at a point in time. Let’s see the PCR of Open Interest.
For instance, the open interest of puts on the Nifty 10,600 strike is 37 lakh contracts, and open interest calls for the same contract, and expiry is 47 lakh contracts.
PCR (OI) = 3700000/4700000 = 0.78
Even here, the PCR (OI) movement trend is more critical than the absolute numbers. Traders can also calculate PCR based on the increment of open interest contracts (OI) to get a clear picture.
PCR as a Contrarian Indicator
PCR is a contrarian indicator that helps traders not get caught in the herd of the market movement. Based on the extreme PCR levels, the trader takes a call to buy or sell against the prevailing market sentiments. It implies that if a trader considers a high Put Call Ratio, say 1.3, as a great opportunity for buying because they believe that the market trend is extremely bearish and will adjust soon. Thus, they make their strategies accordingly.
However, there is no correct number to gauge whether the market is at the top or bottom. Traders anticipate this movement by comparing the current ratio levels to an average ratio over a period of time. This helps to gauge if the market sentiment has changed recently.
For instance, a very high PCR signals an extreme bearish market sentiment. Also, it signifies that the market may bottom out and show some upward trend. On the other hand, if the PCR is at a very low level, it signals an extreme bullish market. Also, it signifies that the market is too bullish and can show some pullback signs.
Importance of Put Call Ratio
The following is the importance of Put Call ratio –
- It serves as an effective tool to determine the market direction and mood at a given period of time.
- It directs traders as and when to place their bets on the stocks based on the direction of price movement of underlying securities.
- As a contrarian tool, it helps traders to analyze whether the recent fall or rise in the market is extreme or whether it is time to take the contrarian call. Usually, traders use this ratio as a contrarian indicator when the ratio reaches extreme levels.
- This tool also helps in analyzing the overall trading behaviour of market participants.
Limitations of Put Call Ratio
One of the major limitations of this ratio is it does not always represent changes in market sentiments. The other limitations are –
- Not all companies have their options available. Thus, it is impossible to compute PCR for most stocks.
- Even though it serves as a contrarian indicator, traders must analyze other prominent factors before betting on the prevailing market sentiments.
- Traders must also use PCR and other potent indicators to arrive at effective outcomes.
- Traders must know how to read the PCR chart correctly. Because even a tiny deviation becomes an essential indicator for analyzing the market movement.
Therefore, to make the most of this indicator, traders must know where to find this ratio and how to use it to make informed decisions.
Frequently Asked Questions
One cannot draw any conclusions about a good PCR. The interpretations depend on the market conditions and historical data of PCR of index or stock. However, a high PCR indicates an extreme bearish market trend indicating a buying opportunity.
A low PCR indicates that traders are buying more call options than put options, indicating that they are speculating a bull run in the market.
The reliability of this ratio is high because it is based on the outstanding position of traders in the market. However, when traders use this metric, interpretation is the most important factor.
A PCR of more than one indicates that traders are purchasing more put options than call options and signals a bearish trend going forward.
A PCR of less than one indicates that traders are purchasing more call options than put options and signals a bullish market trend going forward.